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Monday, February 22, 2016

The Fed's Shaky Voice

Last year, the Federal Reserve all but solidified up to four quarter-point rates hikes paired with their positive economic outlook. They based their diagnosis on strong job gains and stable industrial indicators with a careful eye remaining on the low inflation. But that was last year. During the January meeting, Fed officials chose not to raise rates even though only a small quarter-point increase was due. Instead, Yellen and friends blamed volatility on the increase at the end of 2015 coupled with uncoordinated action from the worlds' largest central banks.

The January minutes, that were released on February 17th, allow investors to peek into a very tense, unsure FOMC board that is left with a nonexistent arsenal that they can use to fight the current weaknesses in the global economy. Their words appear to be all they have left in a fight with a trembling global economy. Although, time and time again, the Federal Reserve board finds itself insisting that inflation will eventually rise to where it should be and economic prosperity will follow. The uncertainty surrounding energy prices is once again referred to as the blame for low inflation, and the staff at the Federal Reserve has yet to find a way to placate the worry. Instead, the committee continues to insist upon a 2% inflation outlook that has been pushed back to 2018. In the past year, statements about inflation such as this have become cliches seeking to remedy market turbulence. Commentary is all that the Fed can muster in fighting the deflationary prices as forecasting and analyzing an energy trend appear out of the question.

Far more interesting, perhaps, is the following statement drawn directly from the minutes: "the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary." Typically, the goal of the Federal Reserve is to maintain a healthy balance of inflation and unemployment as dictated by the Phillips curve. If it does this, the institution remains in a good political light. This statement claims that the Federal Reserve has found itself in a bind where inflation and unemployment are behaving similarly. While some call it the "new normal" of slower growth and less productivity, the Federal Reserve must seek to optimize both. The possibility that crude oil may never recover to its original status as the staple of the industrial world describes the potential for a larger paradigm shift. The Fed has disregarded this option as a potential change in the dynamics of inflation and chosen to believe in a recovery. Ditching a plan for potential rate hikes in 2016 can be a dangerous response that has been conditioned by historical data. The Fed may appear to be taking action and changing the financial conditions, but the current market is out of their reach. The FOMC no longer has any weapons in the fight for inflation stability and unemployment optimization. Because the Fed Funds rate has been left so low, the unhealthy change in expectations has endangered investor capital. The inverted yield curves and record low Treasury bond rates have forced lower returns and lower expected returns in the near future. The Federal Reserve should focus on raising rates gradually so that investors can exit equities when they need to and generate a higher yield in fixed income. Meanwhile, they should acknowledge that mitigation of the current inflation and employment trend is futile while conceding to the possibility of major shifts in energy trends.

Pictured above is a chart following Conference Board's leading economic indicator index over the past 17 years. The latest press release came out last week with January's index falling 0.2% from the December level. Compared to previoud peaks before recessions, both the blue and red lines appear to be closing in on a similar pattern which could mean that one is on our doorstep. The Federal Reserve had other projections. GDP is expected to resume a healthy recovery fueled by increases in consumer spending as inflation begins to recover. Credit and capital markets appear minorly squeezed with risky assets being avoided, a trend not expected to last. Does anyone else find the rosy remonstrations in the minutes a little much? The past two Chairpersons of the Federal Reserve took large steps to encourage transparency in the monetary policies that were developed there. Press releases and interviews are accompanied by staff projections that seek to "guide" the market as the Fed thinks it should. The January minutes even have a whole paragraph written about a discussion of the inflation target and how miscommunications can lead to misdirection in the market. Inflation targetting was not suggested by Bernanke as a way to bully the markets into accepting a given rate of inflation; instead, the old chairman suggested it be used as a tool to adjust expectations. Yellen's Fed has misunderstood this. The constant reiteration of the 2% inflation rate has made investors place too much weight in this indicator which is something that the Federal Reserve only has small amounts of power over. Monetary institutions should center their communication around interest rates and pricing capital and credit because they can directly control this. Using an unconventional technique such as inflation targeting can upset the stability in market expectations and have the opposite effect. The minutes from January show that the Federal Reserve has continued its attempts to "coax" the market into stability and "control" inflation by the assigned target. These practices are unhealthy and have lead to incompetencies in the actions by the Federal Reserve. Hopefully, this year they will be recognized and corrected.